Is the 130/30 price right?

130/30, Fees 28 Nov 2007

For decades, the climax of the US game show The Price is Right has pitted two contestants against each other as they try to guess the value of a large package of prizes.  It’s called the “Showcase“.  Showcase contestants have to guess the fair value of a smorgasbord of prizes.  Problem is, there are so many prizes that it’s virtually impossible to juggle all the moving parts.  In desperation, contestants invariably turn to their relatives in the audience for help (although they can never seem to quite understand the emphatic hand signals their families flash at them amongst the cacophony of hoots and hollers that fills the studio during this segment).

Institutional investors are probably feeling the same confusion about 130/30 fees.  There are so many moving parts, no common standards and a lot on the line.

With hybrid investment products such as 1X0/XO, concentrated funds, and alternative beta funds blurring the lines between alpha and beta, comparing prices (fees) between funds is becoming more complex than ever.  Earlier this week, we covered a new academic study that attempted to back-up performance fees to analyze the behavior of hedge funds’ gross returns.  We’ve discussed how temporary fee cuts during rough spots may be nice for investors, but can provide managers with a much needed tail-wind on returns.  And not long ago, we suggested that it was feast and famine in the investment management industry, depending on whether you were a provider of alpha or beta.

Now Pensions & Investments has brought up the sticky issue of 130/30 fees.  P&I describes 1X0/X0 pricing as a “free-for-all” and cite a myriad of different fee models from pure management fees to pure performance fees and from “traditional” (read: low) to “hedge fund” (read: high).

Monday’s academic study put a price on the option embedded within the asymmetry of a performance fee (the manager can win, but she can’t lose).  But it seems that the academics are the only ones doing that.  Investors sure aren’t.  If they did, then there probably wouldn’t be so much confusion.  Says P&I:

“One consultant, who asked not to be named, said fee issues regarding 130/30 strategies are a long way from being settled.

The initial entrants tended to be the quants. Typically they’re charging a flat fee of roughly 60 to 70 basis points. You’re now seeing a second wave of traditional stock pickers getting in. They charge a flat fee and performance over a benchmark.

The question will be with hedge funds coming in, will they be able to charge hedge fund fees? So far, that’s not been the case, the consultant said.”

Experts cited in the article say that many 1X0/X0 funds are on sale right now in an effort by managers to secure seed money and start the track-record clock ticking.  Some said that most managers charged a flat management fee rather than a performance fee.  But with 11 out of 15 managers surveyed by P&I saying they offered clients a choice of management or performance fees, it would serve investors well to take a more scientific approach to valuing the “performance fee option”.  At least that would provide them with a starting point.

It would be like having Myron Scholes in the Price is Right studio audience waving his arms at you emphatically, mouthing the words “delta hedge!” during your next 130/30 Showcase.

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